Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services.

There Won't Be a Bubble 2.0

The dot-com bust left deep scars on investor (and corporate) psyches.

After investors slobbered like Pavlov's dogs for years over the inevitable Facebook IPO, its closest proxy finally made its big debut. Zynga(Nasdaq: ZNGA), which derives nearly all its revenue from the social giant, recently began life as a public company worth $8.9 billion at a starting price of $10 a share. Strong interest was supposed to drive the stock to LinkedIn(Nasdaq: LNKD) heights, but its disappointing first-day performance seems like the surest sign yet that Internet Bubble 2.0 simply isn't happening.

A history of IPO madnessToday's IPO market is a virtual ascetic compared with 1999's googly-eyed lunacy, when Geeknet(Nasdaq: GKNT), formerly VA Linux, popped like no other IPO before or since. Originally priced at $30 per share, the unprofitable company inexplicably closed its first day at more than $242, for a gain of more than 700%. It's now worth $17, which is really more than it deserves after remaining unprofitable for all but two years since going public.

The former VA Linux was hardly alone leading investors on a long ride down a bad road. In 1999, 115 companies doubled on their first day in a yearlong orgy of irresponsible offer pricing and slavering casino-style drunken speculation that may never be equaled in our lifetimes. Two years later, more than a fifth of the Class of 1999 had dropped off the exchanges. Of the remainder, more than half had lost 50% or more of their value.

A bad year for long-term holders, to be sure, but the history of IPOs is littered with early pops followed by longer-term drops. Less than a third of the annual IPO classes studied by Prof. Jay R. Ritter did well for buy-and-holders after going public -- the average three-year post-IPO return from 1980 onward lost out to the broader market's performance by 11%. However, most of them had nice debuts, rising an average of 14% on their first trading days.

Source: Prof. Jay R. Ritter, University of Florida.Excludes REITs, closed-end funds, partnerships, and banks and S&Ls.3-year return does not include ADRs. Returns tallied for all but class of 2010.

Changing of the guardThe long-term average masks a more recent trend steering the IPO market away from its wilder excesses. In the decade since the dot-com crash, far fewer companies have gone public, and they've gotten better at producing viable returns. From 2001 to 2010, the average newly public company has outperformed the market by 4%.

Source: Prof. Jay R. Ritter, University of Florida.Excludes REITs, closed-end funds, partnerships, and banks and S&Ls.3-year return does not include ADRs. Returns tallied for all but class of 2010.

Despite the post-crash Dow's (INDEX: ^DJI) growth (it sported annualized returns over 10% for the five years after hitting bottom), the IPO market has yet to see anything approaching 1996, when nearly two companies went public every single day. More than four times as many companies, on average, went public each year from 1991 to 2000 as have each year since.

It's obvious something's changed. There are still occasional first-day doubles -- Quihoo(Nasdaq: QIHU) and LinkedIn are this year's outliers -- but since the wheels came off the party bus in 2001, only five others have reached such heights.

A generational shiftIPOs aren't necessarily supposed to outperform, but for much of the past decade, they have. Companies should be eager to go public to fuel their growth, but they haven't been. Something, at least for now, seems to have shifted.

The only comparable period is the flat market of the '70s and early '80s, when fewer than 600 companies went public in a 10-year stretch. Yet smart investors then, as now, have options for long-term greatness. FedEx(NYSE: FDX) has been an 80-bagger since its 1978 IPO, even before accounting for reinvested dividends. It's too early to say whether any of 2011's IPO class will reach those heights in 30 years, but there are some that could bring big rewards to patient investors.

Tech startups might be afraid of Bubble 2.0, but another factor affecting their desire to go public is an explosion of venture-capital funding. Last year, private companies got $23.7 billion in funding, which approached the $30.7 billion American companies raised in IPO proceeds during the same time. This year, venture capitalists could feed startups $30 billion in funding.

Zynga, as a prominent example, has raised $845 million in venture capital since its founding. A company with promising prospects rarely has a difficult time getting money to fuel its growth.

Far from foolproof, but much better than beforeWhat's a patient investor to do with this more restrained IPO market? Zynga's tepid debut smells like bubble backlash, as the market remembers steep declines of the early aughts. It also recalls the hype machine that sent one-time darlings LinkedIn and Groupon(Nasdaq: GRPN) to big gains on their first days, despite long-term uncertainty over their core businesses.

Zynga's in a similar boat right now. It's lashed fast to Facebook, which it mentions 223 times in its most recently amended S-1 filing, and is reliant on a small percentage of fanatical users who buy virtual gewgaws. However, it's undeniable that these Internet stars, as well as most of the 2011 IPO class, have far stabler business models than most dot-com-bubble darlings. That doesn't make them great buys, though. The best IPOs are just as likely to be companies that fly under the radar.

Foolishly public final thoughtsThe combination of easy venture capital, persistent bubble fears, and more accessible information has brought many popular IPOs to market at valuations indicating fully mature businesses. It's quite unlikely that Zynga will be a big gainer at its current price. How much bigger can a company with 227 million monthly gamers get? That's why I'm staying away for the time being and will be giving it a thumbs-down in CAPS until it can show that it deserves to be valued as richly as other online gaming champions.

Don't get caught up in the hype. Companies with years of history can be much better buys than the hottest IPOs, which is why The Motley Fool has put together a free report for our readers on what our analysts believe will be the top stock of 2012. Thousands have discovered its winning ways, and you can find out more -- get your free copy of this important report while it lasts.

Author

Alex Planes specializes in the deep analysis of tech, energy, and retail companies, with a particular focus on the ways new or proposed technologies can (and will) shape the future. He is also a dedicated student of financial and business history, often drawing on major events from the past to help readers better understand what's happening today and what might happen tomorrow.